Why Passive Index Investing Is Merely An Illusion

While I think that index funds are fantastic tools for investors who do not want to spend a lot of time thinking about the stock market, and while John Bogle has done a commendable job of providing opportunities to the small investor, I still think it is a mistake for investors to think of the S&P 500 Index or the Dow Jones Index as "passive indices."

Both indices are actively managed. The editors of The Wall Street Journal determine which stocks are components of the Dow Jones Index, and Standard & Poor's has a committee that selects the 500 member companies of the S&P 500. While I suspect most investors know this is true at some level, I want to highlight the most important story in American index investing history that brings home this point.

In 1939, the committee that controlled the Dow Jones Index chose to eliminate International Business Machines (NYSE:IBM) from the index (the committee did not disclose the reason why IBM was removed). IBM did not rejoin the index until 1979 and, according to research conducted by Norman Fosback, the Dow Jones would have been twice as high in 1979 if IBM had remained in the index continuously from 1939 to 1979.

Oftentimes, we look back on history and reflect on how long it took an index like the Dow Jones to recover from the worst of The Great Depression, but our entire portrait of the stock market's past is colored by the fact that the Dow Jones committee elected to remove IBM from the index for some reason in 1939:

It's unclear when the Dow would have returned to its 1929 pre-crash high had IBM not been deleted in 1939. In response to a request, an analyst at the indexes division of Dow Jones said that it was unable to determine the answer. But because IBM's stock was one of the best performers during the 1940s, greatly outpacing the Dow itself, it's certain that its inclusion would have markedly accelerated the index's recovery.

IBM is the most egregious example, but it reminds us that inclusion in an index is the result of active management. Heck, Berkshire Hathaway (NYSE:BRK.B) did not get included in the S&P 500 until 2010 because the S&P committee did not believe that the company was liquid enough due to its high share price. By that time, Berkshire was already one of the three dozen largest publicly traded companies in the world. If some member of the S&P committee insisted on adding Berkshire in the 1980s, the total returns of the index would have greatly increased due to Berkshire's superior growth of 15%-18% during that time frame.

I think it is an important moment in an investor's journey when he or she realizes that a stock market index is not some magic box that grew by 10% every year during the 20th century. Rather, that figure reflects the growth of specific companies that were deliberately chosen by different committee members. Once you realize this, you may start seeing flaws in the index construction everywhere you look.

For example, the Dow Jones is price weighted. That is an absurd way to construct an index. Should Chevron (NYSE:CVX) really have six times the weight of General Electric (NYSE:GE) simply because the board of directors at Chevron chose to cut the company up into 1.9 billion pieces, while the Board of Directors at General Electric chose to cut the company up into over 10 billion pieces? That seems like a logically questionable method to form an index.

In the case of the S&P 500, it is free float capitalization weighted. A consequence of this fact is that as a stock becomes more overvalued, it comes to increase an ever-growing amount of the index. Right now, Exxon Mobil (NYSE:XOM) is about 3%-4% of the index. If, for some wild reason, the market participants bid the price of Exxon up from $90 per share to $180 per share, it would end up representing about 7% of the overall index (assuming the other stock prices remained the same).

Of course, I do not envision Exxon becoming an $800 billion company anytime soon, but I did want to call your attention to the fact that if a company goes from trading at 15x earnings to 30x earnings, it will come to represent a larger part of the index. This creates a perverse system: As a company becomes cheaper and more undervalued, it gradually becomes a smaller part of the index. And as it becomes more expensive and more overvalued, it comes to represent a larger part of the overall index. Unfortunately, that is about the only part that is passive about an indexing strategy.

There is no passivity about the construction of market indices. The Wall Street Journal picks 30 companies to be in the Dow Jones, weighs them by price, and then your total returns and dividends received are due to the combination of 30 companies that they have chosen. Likewise, the S&P committee gets to choose the 500 companies that they claim represent the market. By owning an index, you are outsourcing your thinking to the judgment calls of The Wall Street Journal editors and the S&P 500 committee members. If you ever think that index investing is truly "passive investing," just remember the consequences of the decision to remove IBM from the index from 1939 to 1979.

Disclosure: I am long GE, IBM, XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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